Market’s Trump trades at risk from bond vigilantes

Moelis & Company

21/11/2024 08:00

(The author is a Reuters Breakingviews columnist.  The opinions
expressed are his own.)
    By Francesco Guerrera
       LONDON, Nov 20 (Reuters Breakingviews) - Markets
have experienced a “Trump bump”. The euphoria among equity
investors, cryptocurrency fans and dollar-loving currency
traders stems from U.S. President-elect Donald Trump’s
deregulation and tax-cut pledges. But running such a hot economy
would also make the deficit and inflation soar, unsettling debt
markets. Bond investors could make America small again.
    In the end, it was the inflation rate, stupid. The famous
quip by Bill Clinton strategist James Carville about the
economy’s importance in U.S. presidential elections has been
rewritten by Trump’s triumph. Despite presiding over strong
growth and low unemployment – and a fall in the pace of
inflation – voters penalised the incumbent Democratic Party
because of the steep rise in the cost of living.
    U.S. consumer prices are 21% higher now than when outgoing
President Joe Biden won the previous election in 2020, official
data shows. In the 10 key states that sent Trump back to
Pennsylvania Avenue, three out of four voters said inflation had
caused them moderate or severe hardship over the past year,
according to exit polls by NBC. Most of them also said
they voted Republican on Nov. 5.
    Ironically, Trump’s stated policies are likely to stoke
inflation. That’s particularly true for his pledge to slap 10%
tariffs on all imports, as well as 60% levies on China-made
goods. An increase of that magnitude would raise the effective
duty on U.S. imports from 2% now to around 17%, according to
Dario Perkins at TS Lombard, which would be a post-1940s peak.
That, in turn, would add 1.3 percentage points to the consumer
price index, equivalent to a 20% spike in oil prices, he
calculates. To put that in context, CPI rose at an annual rate
of 2.6% in October, already above the Federal Reserve’s 2%
target.
    Equity investors don’t seem overly worried: the benchmark
S&P 500 Index soared after Trump’s victory. It has dipped since
but remains above its pre-election level. As befits an age where
different portions of society believe separate and conflicting
narratives, the financial community is hearing what it wants to
hear from Trump – namely, the president-elect’s promise to
deregulate vast swaths of industry, with the help of
private-sector allies like Tesla’s  TSLA.O  Elon Musk. The
belief that these policies might unleash a mergers and
acquisitions boom has boosted the stock of investment-banking
boutiques like Moelis  MC.N  and PJT Partners  PJT.N , whose
shares are up about 10% since Nov. 5.
    Fund managers also like Trump’s idea of cutting corporation
tax to 15% from 21%, which seems more plausible now that the
Republicans control both houses of Congress. That would add 4%
to the average company’s earnings per share, according to
Goldman Sachs. Traders have even found a silver lining in the
prospect of trade wars. The Russell 2000 Index of
small-capitalisation stocks briefly outperformed the S&P 500,
partly because investors believed that protectionism would help
domestically focused firms.
    At the other end of the Trump trade spectrum, bitcoin has
risen by more than a third since Nov. 5, on the back of the new
president’s promise of making the United States the “crypto
capital of the planet”. The euphoria of so-called “risk assets”
like stocks and digital currencies is understandable. A fiscal
loosening, coupled with ongoing Federal Reserve rate cuts and
deregulation, is likely to add to already-heady economic growth
rates. The International Monetary Fund expects U.S. GDP to
expand by 2.8% this year and 2.2% in 2025, which is much faster
than in many other Western countries.
    But there will be costs, mostly borne by the public coffers.
Trump’s policies could add up to $15.5 trillion to the country’s
budget deficit in the next decade, according to the non-partisan
Committee for a Responsible Federal Budget. Since the deficit
already exceeds 7% of GDP, such a fiscal splurge could call into
question the sustainability of Uncle Sam’s finances.
    Bond markets have noticed. The yield on 10-year U.S.
government debt has risen from 3.6% in September to around 4.4%
for two reasons: fears that the Fed will have to keep interest
rates higher than otherwise due a Trump-led inflation
resurgence; and investors’ desire to be paid more to compensate
for the risk of higher debt levels.
    The optimists argue that the Treasuries can withstand such
shocks without collapsing in the way that UK gilts did in 2022
after a package of unfunded tax cuts by then-Prime Minister Liz
Truss. The dollar is the preeminent global currency, ensuring
strong foreign demand for U.S. assets such as government bonds,
or so the argument goes.
    The problem is that rising bond yields undermine the case
for owning equities even if Trumponomics is less devastating
than Trussonomics. Higher returns on bonds, which are a safer
asset than stocks if held to maturity, can lure investors away
from equities. That’s especially true if, as is the case now,
key benchmarks like the S&P 500 trade at high valuations.
Another problem for stocks is that higher bond yields imply
chunkier discount rates for far-off cash flows, reducing the
present value of equities.
    Of course, the famously voluble tycoon could renege on his
campaign promises once in the White House or dial them down if
he sees that the economy and markets are taking it badly. But if
he sticks to the script, the next leg of the Trump trade may be
to go short everything that’s been rising so far.
    Follow @guerreraf72 on X

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Graphic: US prices have risen sharply since Joe Biden’s election
   https://reut.rs/4fxeK3W
Graphic: US small-cap stocks surged after Trump’s victory    https://reut.rs/3UXoIU0
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 (Editing by Liam Proud and Oliver Taslic)
 ((For previous columns by the author, Reuters customers can
click on  GUERRERA/ 
francesco.guerrera@thomsonreuters.com))